Problem 1 (10 points):

Assume that you use Purchasing Power Parity (PPP) to forecast exchange rates. You expect that inflation in France the next year will be -1.0%, and inflation in the US will be +2%. Assume that you are considering the purchase of five one-year euro call options from PHLX with a strike price of $1.08/. The premium is 0.5 cents per . Today the spot rate of the euro is $1.06/. The one-year forward rate is $1.07/.

• 1. Based on your PPP analysis, what will be your expected spot exchange of $/ in one year?
• 2. Graph the call option cash flow schedule at maturity. Mark clearly where will be option's break-even point.
• 3. Determine your expected profit (or loss) if the euro appreciates to your expected future spot rate.
• 4. Determine your expected profit (or loss) if the euro appreciates to the forward rate.

(Note: One PHLX euro option contract covers 10,000. For simplicity, ignore the time value of money)